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Real Estate Sector Rating: Marketperform

Real estate sector overview

Low interest rates can make dividend-paying equity real estate investment trusts (REITs) more attractive, a factor that has supported them in recent years. Apartment and office markets have been generally strong, supporting rents; however, supply is rising, which could pressure profitability. Also, an ongoing shift away from brick-and-mortar retailers could pressure mall REITs, but that story seems well known and we recently upgraded the sector to marketperform.

Market outlook for the real estate sector

The real estate sector has outperformed at times in the recent past as longer-term interest rates had stagnated at still relatively low levels. However, the recent shift in sector leadership to more defensive groups that we’ve observed, combined with our belief that the “death of brick-and-mortar retailers” story is overdone, led us to upgrade our rating of the real estate sector to marketperform from underperform, and the sector has benefitted from the overall market volatility over the past couple of months. Home affordability is also at a 10-year low, according to the National Association of Homebuilders, which could lend support to the apartment area of the market.

There are still areas for concern, but in our minds fewer than a few months ago. For instance, apartment demand has been strong and rental rates have risen—but as often happens, businesses have seen a need and rushed to fill it, which could result in an eventual oversupply in the apartment area. Retail REITs also face some headwinds, but, as mentioned, this is an area on which we’re becoming more positive. As longtime readers of this publication know, I am not a believer in the “death to brick-and-mortar” story that seems to be told quite often. From media reports you would think online sales have completely overtaken brick and mortar, but e-commerce made up only about 9.6% of total retail sales at the end of Q2, according to the U.S. Census Bureau.

One last major concern has been reduced. REITs have been able to borrow money at low rates in order to increase their holdings and potentially their income. Rates have risen, with the 10-year Treasury yield moving decisively above the 3% mark lately. That’s still low by historical levels, but a continued move higher would cause us more concern.

Apartment trends: Due to the financial crisis and housing crash, as well as demographic factors, demand for apartments has been strong, supporting rental rates and benefiting those companies that have a stake in that arena.

The change in the tax code could help make REITs more attractive in taxable accounts due to a change in the taxation of passive income.

Negative factors for the real estate sector include:

Resumption of rising interest rates: Higher rates would likely raise the cost of financing, and could make the yield provided by the group less attractive.

Apartment trends—part 2: This has been a positive factor but we may be at an inflection point, where supply starts to exceed demand and Millennials start to be more attracted to houses.

Changing consumer: There has been a move toward online shopping, away from brick-and-mortar stores, which could hurt certain mall-related investments as department stores pare back the number of locations.

Schwab Sector Views do not represent a personalized recommendation of a particular investment strategy to you. You should not buy or sell an investment without first considering whether it is appropriate for you and your portfolio. Additionally, you should review and consider any recent market news.

All expressions of opinion are subject to change without notice in reaction to shifting market conditions. Data contained herein from third-party providers is obtained from what are considered reliable sources. However, its accuracy, completeness or reliability cannot be guaranteed. The above mentioned company(s) should not be construed as a recommendation or endorsement

Diversification strategies do not ensure a profit and do not protect against losses in declining markets.

Indexes are unmanaged, do not incur management fees, costs and expenses, and cannot be invested in directly. Past performance is no guarantee of future results.

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